Market Drivers

The recent outbreak of a dangerous respiratory illness caused by a new Coronavirus in China was widely blamed for the stock market sell-off on Monday last week. It is undoubtedly true that the epidemic has the potential to severely disrupt economic activity, although it is too early to come to a definitive conclusion about that. Be that as it may, the event actually serves as an excellent example illustrating that the news of the day are incidental to market action rather than causing it.

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S&P 500 Index, 10-minute chart. A fairly strong sell-off on Monday last week, a vigorous rebound on Tuesday.

Consider the vigorous market rebound on Tuesday depicted above. Did news about the epidemic get better? Quite the contrary, news on the spread and deadliness of the illness actually worsened substantially. Granted, the rebound failed to completely make up for Monday’s losses, but at this stage the market is certainly not “discounting” the potential economic impact of the epidemic.

We would actually argue that the market was ripe for a setback regardless of the news accompanying it – and it certainly remains vulnerable. After the sell-off on Monday, a headline at Zerohedge informed us that Morgan Stanley analysts immediately concluded that “The Correction Has Begun, But The Fed Will Keep It To 5%“. It is heartwarming to see that the superstitious belief in the magical powers of “potent directors” to prevent market downturns remains alive and well.

We would suggest that if risk aversion actually makes a comeback, there is precisely zero the Fed or anyone else can do about it. Mind, we are not asserting that money printing does not affect interest rates and asset prices, but no-one can control the time lags involved, or which assets will be the beneficiaries. Naturally, we concede that the Fed’s policy bias u-turn in late 2018/early 2019 and the sizable jump in the money supply since last September have helped the recent blow-off type rally in the stock market along.

However, this was predicated on the fact there was genuine fear in the market at the late 2018 correction low and that risk appetites have gradually, but steadily increased again ever since. Furthermore, although some evidence of deteriorating economic conditions has emerged, a recession has to date remained out of sight. As the monthly Merrill Lynch fund manager survey revealed, the combination of renewed central bank largesse and a weak– but not too weak – economy has emboldened previously cautious fund managers to venture back into the market with great gusto.

All these conditions remain in place, but two things have changed: for one thing, stock markets around the world are now trading at far higher levels and multiples– the valuation of the US stock market, in particular, is extremely stretched by historical standards. Valuation is, of course, a long term concern and has no bearing on market action in the near term.

For another thing, there is the current positioning and sentiment backdrop, which may indeed have bearing on short term market action: compared to late 2018 low, it has essentially reached the opposite end of the spectrum. Below are a number of charts that have caught our attention in this context. They strongly suggest that utmost caution is advisable – and should the market reverse and continue to rise in the short term, these indicators will probably deteriorate even further.

On to the charts, which follow below – the charts are grouped thematically and annotated. Below the charts you will find brief explanations as to what precisely they show.

Options

We begin with a number of option-related charts. Apart from charts of widely used volume put-call ratios such as the CBOE equity P/C ratio, we include a few option indicators that are perhaps less well known in order to provide additional granularity (they may also induce vertigo in this case…).

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Put-call ratios, overview.

 These are traditional volume put-call ratios, which simply show call trading volume divided by put trading volume. From the top: CBOE equity only P/C ratio, daily; 10-day moving average of the CBOE equity P/C ratio (the recent low at 0.48 was a rarely seen extreme); CBOE combined equity and index P/C ratio, daily; CBOE index P/C ratio, daily. All these ratios have recently hit very low levels, but it is noteworthy that index options displayed slightly less enthusiasm (see also the comment on OEX options further below).

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Options Speculation Index; this is a very interesting proprietary contrary indicator developed by sentimentrader.com. Here is how it is constructed:“The index takes data from all the U.S. options exchanges and looks at opening transactions. We total the number of transactions with a bullish bias (call buying and put selling) and also the number of those with a bearish bias (put buying and call selling). The Index is a ratio of the total bullish transactions to the total bearish transactions.” Readers may wonder how one can detect the intent of a transaction (i.e., whether a call/put was bought or sold); this can be done by differentiating between transactions taking place at bid and ask prices; note also that only opening transactions are included. Note: The recent peak in this index was only exceeded in Q1 2000, right at the top of the tech mania.

Small trader call buying; “The indicator is constructed by computing the percentage of total small trader option volume that went to buying call options. It looks at transactions that are buy-to-open only, and only for those trades that are under 10 contracts.” In short, this indicator reflects the emotions of the smallest of traders. As noted on the chart, they haven’t been this enthusiastic since 2007.

This brings us to a confirming rather than contrary options indicator, the OEX put-call ratio. Here are two aspects of it:

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S&P 500 index. In the 1980s, OEX options were the by far most popular and most heavily traded index options. In the meantime they have become the playground of large and sophisticated traders, who use them as hedges as well as for directional bets. As sentimentrader explains: “Unlike the total and equity put/call ratios, the OEX put/call ratio should be considered in a non-contrarian manner. Perhaps due to the generally higher premium (cost) of index options as opposed to equity options, OEX options appear to attract a more sophisticated trader, or at least those who are more adept at timing the market. Market turning points often coincide with extreme OEX put/call readings – when the put/call ratio is low, we are often near a market low. Conversely, when the put/call ratio is high, meaning OEX traders are betting heavily on a market drop, we often see market declines shortly afterward.”The same applies of course to the OEX open interest (OI) P/C ratio – in fact, the persistent accumulation of open put positions is particularly concerning. We would also add the following qualifier: the bearish signal given by a sharp surge in OEX volume and OI P/C ratios is especially meaningful when it coincides with extremely low equityP/C ratios (as is currently the case).

RYDEX Data

We move on to Rydex data now; while the size of Rydex funds is dwarfed by ETFs these days, we believe Rydex ratios continue to be meaningful indicators of small to medium-sized trader sentiment. Recent developments in these ratios are quite stunning – and that may be putting it mildly.

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Rydex data. From the top: Rydex money market assets; the pure (non-leveraged) bull/bear assets ratio; total bear assets. All of these are remarkable, but the disdain for cash really stands out for us. Bear assets can almost not decline any further, since they are very close to zero already (and down 95% from their peak levels). It is noteworthy that although it is at an extreme level, the bull/bear ratio has actually diverged bearishly from the major indexes by putting in a lower high compared to early 2018.

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Leveraged Rydex bull/bear ratio. As sentimentrader explains: “The most popular Rydex funds are based on the S&P 500 and Nasdaq 100, which make up the vast bulk of index assets. This indicator shows the total amount of assets invested in the leveraged bullish funds divided by the total amount of assets invested in the leveraged bearish funds based on those two indexes.” As pointed out in the chart annotation, readings above 20 were previously almost unimaginable. This is an outbreak of collective insanity in a class all its own (of course it has been profitable so far, but the persistence and intensity of the bullish consensus it reflects is nevertheless a major warning sign).

Miscellaneous – Short and Long Term Positioning Indicators, Narrowing of Leadership, Valuations, etc.

Next is one more short-term sentiment indicator that has frequently proved useful in the past – the NAAIM exposure index. NAAIM stands for National Association of Active Investment Managers. The exposure index is based on a weekly survey, which asks about the stock market exposure of members in terms of a range from “200% leveraged short” to “200% leveraged long”. The replies are tallied and averaged, and the NAAIM exposure index is the result that can be plotted over time and compared to the market’s performance.

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NAAIM exposure index: as the chart illustrates, short term market peaks are usually aligned with extremes in average exposure near the 100% level. Conversely, correction lows as a rule tend to coincide with very low NAAIM exposure index levels.

Next we show three indicators of long-term significance: the mutual fund cash-to-assets ratio as well as AAII cash and stock allocation levels. These have obviously no bearing on short term timing, but they warn that the next bear market will probably be severe (irrespective of when it actually begins).

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Long term positioning indicators

. From the top: Mutual fund cash-to-assets ratio (which recently fell to a new all time low of 2.8%); AAII cash allocation in %;AAII equities allocation in %. AAII stands for “American Association of Individual Investors” – the allocation percentages are determined via a survey of members.

Our last chart shows something that is truly unique (in this respect the current time period does in fact qualify as a “new era”). Somehow the rally in the stock market has not only managed to lead to concentration in a handful of names (the top five by market cap to be precise) that is rivaled only by that seen at the 2000 tech mania peak, but at the same time there have never been as many individual sectors trading at record valuations.

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percentage of sectors in the S&P 500 index trading at record valuations.

This information is of course also irrelevant with respect to short term market action, but it represents a strong warning for long-term investors. It is reasonable to surmise that stock market returns over the next decade will be very different from those achieved in the last decade. Depending on one’s age and willingness to take risk, one should probably think about a “plan B” at this juncture.

Conclusion

With the central bank printathon currently in full swing again, we prefer to remain agnostic with respect to the question of how much further the bubble can ultimately expand. Having witnessed bubbles such as that in the Nikkei in the 1980s (peak P/E ratio almost 90) or that in the Nasdaq in the late 1990s (peak P/E ratio above 300 if memory serves, and well above 40 in the S&P 500), we are well aware of what is possible (of course, what is possible is not necessarily likely).

However, current sentiment and positioning data strongly suggest that a sizable setback may be at hand. This does not depend on Corona virus-related news: in fact, if a short term advance coincides with an improvement in the news backdrop on the epidemic, the market will likely end up in an even more vulnerable position. We believe one should be very cautious in coming days and weeks, refrain from chasing rallies and think about ways to protect existing positions.

Caveat emptor, as they say.

Charts by stockcharts, sentimentrader, Dow Jones, Bloomberg/Crescat Capital